Marshall, who advocated that price is determined by the forces of demand and supply, gave a great importance to the time element in the theory of price. He was of the view that equilibrium attained by the demand and supply is unstable in the short run.
However, as the time elapses, equilibrium becomes stable. In other words, in the short run, equilibrium price may be higher or lower than the average cost of production. But, in the long run, there will be greater tendency of equilibrium price being equal to the average cost of production and firms earn only normal profits. Thus, the supply responses to demand changes are not the same in different time periods.
The role of time element is of great significance in the determination of price, since one of the two determinants of price, namely supplies, and depends on the time involved to it for adjustment. Time is short or long according to the extent to which supply can adjust itself. Marshall divided time into three periods from the view point of supply.
1. Market Period or Very Short Period:
Supply takes time to adjust itself to a change in the demand condition due to the nature of technical conditions of production. A period of time is required for changes to be made in the size, scale and organisation of firms as well as industry.
The market period is such a very short period that no adjustment can take place in supply conditions in response to a change in demand. Supply in the market period is limited by the existing stock of the good from the production in the past period. It is not related to the production in the current period.
Additional units of a commodity cannot be produced and supplied. The market period is so short that new firms cannot enter the industry nor can existing firms leave it. Thus, there is no scope for raising the production in any way. In other words, supply remains perfectly inelastic. Supply being static, the price is governed by the position of the demand curve on the inelastic supply curve.
Larger the demand, higher will be the price and vice-versa. Thus, demand plays a main role in the short period. This situation can be explained with the help of a diagram. In Fig 11.6, supply curve SS is vertical indicating that the supply is perfectly inelastic. DD is the original demand curve which intersects the supply curve at point ‘E’.
At OP price, OS units are supplied. Increase in demand shifts the demand curve to D’D’ and the price increases to OP1 as a result. Conversely, a decrease in price shifts the demand curve to the left to D”D” and the price falls to OP2. However, quantity supplied remains the same, that is, OS.
Fig. 11.6: Price Determination in Market period
The market period may be a day or few days or even a few months depending upon the nature of the good or occupation. For instance, in case of perishable goods, like food, the market period may be a day and for a cotton cloth, it may be a few weeks.
Market period can be increased by having storage or cold storage facilities. On the other hand, durable goods can be held back. Out of a given stock of such goods, sellers will be prepared to sell a lesser amount at lower price, and a greater amount at a higher price.
At same price, they will be willing to supply the whole stock of the good and beyond that price, the supply of the good will become perfectly inelastic. Thus, the supply curve of a durable good slopes upward to a point and becomes a vertical straight line after that. Further, in agriculture, market period may be few months. In industry, where production in continuous, market period may be only of a few days.
2. Short Period:
Short period is that operational period in which supply can be adjusted to a limited extent. In a short period, new firms cannot be set up and the techniques of production cannot be altered. However, supply can be increased by only making better and intensive use of the given plant or capital equipment or by varying the amounts of variable factors.
Since no new machinery and equipment can be added and no new plants can be set up in the short period, full adjustment of supply to demand is not possible. The producers are able to earn super normal profits in this period. In the words of Stigler. “Economists generally define the short run as the period within which the rate of supply from given plants is variable but the number and size of plants is fixed”.
The supply curve of individual firms is perfectly inelastic, while that of the whole industry is elastic. In short period, demand plays much greater role than the supply in price determination. This is clear from the Fig 11.7. In this figure. ‘E’ is the original equilibrium point and OP is the equilibrium price.
Increase in demand shifts the demand curve from DD to D’D’ and the price increases to OP, as a result. High price induces sellers to increase supply. Now, supply curve shifts to S’S’ and price comes down to OP2. It is evident that increase in demand is more than the increase in supply. Further, equilibrium price in short term is at a relatively lower level as compared with the very short period.
Fig. 11.7: Price Determination in Short Period
3. Long Period:
Long period is a period long enough to enable the firms to build new plants or c abandon old. ones. An industry can adjust its output completely to an increase in demand by permitting new firms to enter the industry and existing firms to increase their scale of production by installing new technology plant and machinery.
Similarly, if the demand contracts, some of the firms can leave the industry and others can reduce their scale of output. Thus, during the long period, all types of adjustments in supply in response to a change to demand are possible, as all the factors on which the supply depends can be changed.
Thus, in the long run, supply plays a crucial role in the determination of equilibrium price. The new equilibrium price is established at the point, where the new supply curve intersects the demand curve. The equilibrium price in the long run will be lower than the equilibrium price in the short run, while the equilibrium quantity will be greater.
This new equilibrium in the long run may rise increasing cost industry), remain constant (constant cost industry) or fall (decreasing cost industry) depending upon the shape of the long run supply curve as discussed in chapter 15. Marshall Calls long period equilibrium price as the normal price and the market price gravitates around it.